Why structurally declining businesses can (sometimes) be interesting

Photo by Markus Spiske on Unsplash

The past decade or so has truly been the decade of “growth”.

The rise of the FAANGs in the US and the “BAT” (Baidu, Alibaba and Tencent) in China has spurred an equal (if not greater) exuberance all around the world, driving capital squarely into companies that investors believe will be their local equivalents, like “The Amazon of Nigeria”, “The Netflix of Southeast Asia” or “The Alibaba of Latin America”. Add to this other themes like electrification of vehicles, cloud computing, renewable energy and financial disintermediation and the exodus from the “old economy” looks like it has only just begun.

The victims of these capital shifts are commonly the champions of yesteryear – from department store operators to TV stations to remittance services to brokerages. These businesses have seen their stocks’ earnings multiples collapse from mid teens to low single digit levels as their growth trajectories have been adjusted lower and lower. 

A crushed multiple.

One well-known example is Macy’s, the US department store operator: from the stock’s high in 2015 when it traded at almost $70, Macy’s stock now trades at $15. Over the same period, its forward earnings multiple has been crushed, from just under 15x forward earnings to 5x forward earnings now. 

While Macy’s, battered and beaten up by competition from the likes of Amazon, earns 28% less than it did in 2015, the market has decided that its stock is worth 78% less. Let’s be clear – we aren’t advocating the view that Macy’s stock is “cheap” and should be bought – certainly not when we tend to steer clear of businesses that lack growth prospects, at least as long positions.

But in the context of the shift from growth to value which we discussed several weeks back, it’s interesting to try and put ourselves in the shoes of a hypothetical “value” investor and work out where the appeal is. After all, it would seem that structurally declining businesses are everywhere looking for buyers, and it would be remiss to not at least entertain the idea of owning some of them.

Finding value.

Advocates of value investing typically seek out some basis for fundamental valuation, most commonly referencing the book value of a company, the value of hard assets which a company owns. The rationale is simple: buying companies that are worth less than the value of the stuff they’re made up of necessarily offers some margin of safety, since in the worst case (or so the argument goes) “even if the company goes bankrupt, we’d recover more than what we paid in the first place.”

More sophisticated deep value investors turn to metrics like “Replacement Cost” as a more accurate representation of how much the physical hard assets of a company are worth, but the underlying concept is the same, essentially attempting to spend $90 to buy a $100 note.

As a majority shareholder in these transactions, they make a lot of sense, since a majority shareholder is entitled to consolidate the newly acquired company into its accounts, permitting the buyer almost full use of the acquired company’s cash and other assets. As it happens, for a company that has a steady (but somewhat slowing) business like running a department store or collecting subscriptions for satellite TV, there is decent cashflow coming into the company’s coffers, with very little opportunity for deploying that cash barring a complete overhaul of the company’s business.

Of course, given some ingenuity, there is scope for financial engineering that could benefit the stock prices of an otherwise ex-growth company, as has been the case with Texas Instruments outlined by Ben Hunt in his blog here.

The cash just keeps coming.

But for most other structurally declining companies, scheming out a narrative change of growing earnings per share and executing that via a complex structure of buybacks and management incentives is one bridge too far. Most businesses just want to get on with it. As a result, cash starts to pile up, with nowhere to go. At the same time, future prospects for the business start to dwindle, further reducing the need to reinvest into the business. Dividends could be paid, but the cash just keeps coming.

The opportunity therefore is for a rapidly growing company, one of the many spawned in the liquidity fuelled exuberance of the past decade, to acquire some of these decently profitable, cash-generating (and sometimes cash-accumulating) businesses at a multiple that is absolutely reasonable by any standards. A company trading at 20x sales and no earnings using its still-abundant cash pile to acquire a target trading at 5x forward earnings and 3x enterprise value, laden with unused cash that keeps coming every year: one couldn’t imagine a better strategy to take.

In our own business, too, we’ve always believed in the mantra that “cash is king” – before going for the moonshot ideas that could (with a smaller percentage chance of success) make us a ridiculous amount of profit, it is more important to secure cash flow. As with our approach to managing money, once the base is secured, everything else is upside. 

Ready, get set, dig.

Does this all mean that every cash-generating “deep value” company is going to get snapped up at a premium and value investors are going to have their day? We don’t know, but if you paid attention to the section above, there was one caveat that you might have spotted – all those “benefits” come primarily to the majority shareholder in those transactions.

We have in the past discussed the key difference between the company and its stock. A majority shareholder who owns the bulk of equity in a company invests in the company; a minority shareholder picking up shares in the stock market invests in the stock. 

But it’s the same thing, just a matter of amount, isn’t it? Quite the contrary. As a majority shareholder, the benefits of profit, cash flow and cash reserves accrue directly to the entire group’s balance sheet. 

As a minority shareholder, the only ways you enjoy those benefits are from selling the stock (hopefully at a higher price than what was paid initially) or from receiving dividends, at the discretion of management – not yours. 

And when it comes to recovering more in a bankruptcy than what was paid in the first place just because you paid below book value, there’s a plethora of reasons why that won’t happen, starting with the fact that the road to bankruptcy is long, costly and a drag on the cash and valuations which we see today. Even worse would be staving off bankruptcy and management (against your protests) agreeing to a trade sale of the company at half the price you paid for it in order to keep their jobs.

Of course, as a minority shareholder, you also don’t need to worry about issues like debt coming back to haunt you (as Malaysian automaker Proton learnt the tough way with their acquisition of British carmaker Lotus, and their subsequent sale to Chinese carmaker Geely). Less control, less responsibility, at least that much is fair.

He who controls the cash is king.

Here’s the bottom line: cash is king, but only if you can control the cash. For a large corporate buying out a cash-generating business at a cheap multiple thanks to the spectre of “structurally declining” over its target, that’s good deal making. The same could be said of activist investors who take board seats and seek to influence the operations of a company.

Yet we, like many public market investors, aren’t deal makers. We don’t pretend to be the gun slinging bankers and financiers in Barbarians at the Gate who walk in, find undervalued companies and flip them around like bartenders do with cocktail shakers. Like many public market investors, we invest in stocks, not companies.

Drawing the line between what makes “good business sense” and “good investment sense” is important. Given enough cash to buy a business that could provide us with strong cash flows and secure our base for the years to come at a reasonable price, we’d definitely want to take a look. 

Investing is a completely different story. To do the same with a small portfolio position in the publicly traded stock of a company that “looks cheap on a 5 year trailing multiple basis” which offers “strong operating and free cash flow”, but which is also effectively seen to be out of growth opportunities by the broader market – for us that would be a trade, at best.